Warren Buffett's Berkshire Hathaway released its annual letter today and in his usual folksy style, Buffett extolled the virtues of his great company and the people that run it. Since Buffett took over Berkshire in 1965 the company has put together one of the best (though not the best) long term investing track records in history.
Even more notably, Buffett has publicly held himself accountable for his company's investment performance, and has developed a number of unique metrics to track it and stuck to them for decades. Buffett compares Berkshire's increases in book value to increases in the S&P index, the reasoning being that an investor can easily invest in the S&P index through a low-cost fund or ETF, and if Berkshire can't grow itself faster than this, shareholders would be better off simply holding the index fund.
For most of Berkshire's history, Buffett handily and famously beat this benchmark, compounding Berkshire's book value at a rate of 19.7% annually vs. 9.8% for the S&P (as of the end of 2013). This 9.9% compounded difference adds up to an incredible 683,677% difference in total return since 1965, which has greatly enriched Buffett and his shareholders.
However, all streaks must come to an end, and this has finally happened at Berkshire. Over the past 5 years, Berkshire's book value has increased by only 17.0% while the S&P has grown by 21.2%. This is the first 5 year period that Berkshire has ever failed this test, and foretells the likelihood that Berkshire's days of routinely providing superior investment performance have come to an end.
The Five-Year Test
Buffett himself developed this 5 year test in his "owner's manual", a supplementary document provided to shareholders describing how Buffett believes his performance should be regarded. As far back as 1983 Buffett wrote:
"We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing
whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained."
After being questioned about this at the 2009 annual meeting, Buffett revised the test as follows:
"The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense."
By either definition, Berkshire unfortunately failed the test for the period ending 2013. By mid-2013, it was pretty clear this was going to happen as the S&P roared to new highs, and Berkshire is simply too large to keep up with 20-30% or higher annual increases. When 2013 finished we all knew that the race had been lost, well before Buffett's letter was published today. I was very curious to see how Buffett would address this when writing to his shareholders.
Buffett has long been critical of corporate managers who either do not track their performance much at all, or track it in a way that they can change the metrics after-the-fact, thus ensuring that they always succeed and earn their outsized bonuses. As he wrote in his 1988 Chairman's letter, "At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands."
Over a very long period of time, Buffett has differentiated himself from these managers by clearly choosing easily calculated metrics, sticking with them, and then beating them. So this begs the question, what would Buffett say when he finally missed the mark?
Here is what Buffett wrote in today's letter:
"Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results."
What the what?! The period from 2007 to 2013 represents six years, not five! Not only that, but the 6th year (2008) represents one of Berkshire's best years compared to the S&P, as he beat the index by 27.4%, his 5th best year since 1965. By including this year, Buffett beats the S&P, but only when he changes the metric he himself wrote 30 years ago to include 6 years instead of 5.
Surely Buffett knows this, yet he provides no further explanation or commentary for this change. This sure looks a lot like he is doing exactly what he has criticized others for - see where the arrow lands and then smudge the lines a little so it's still in the bull's eye. It was stated so casually in the letter that most of the press headlines immediately after the release of the letter did not even pick up on this obvious miss.
Berkshire's Dividend Policy
The backdrop for this is a much larger issue than measuring time in spans of 5 years vs. 6 years. Since 1965 Berkshire has not paid a dividend to shareholders, because Buffett feels that he is able to provide better investment returns by retaining and reinvesting all of Berkshire's earnings. Early in Berkshire's history this policy made perfect sense, because with Buffett's golden touch, shareholders were thrilled to have him manage every dime of the company's capital.
However an inevitability of investing is that when working with ever-larger sums of money, it is simply impossible to continue to produce outsized returns. Buffett has done astonishingly well even as he went from working with millions to working with billions, but Berkshire's largest challenge today is to "move the needle". When other investors have been faced with the same problem, they have returned cash to shareholders through special dividends or other means. But Buffett has steadfastly refused to give in on this issue.
Today the picture is different. Berkshire is an enormous company with nearly 100 subsidiaries and generates enormous cash flows. It grew book value by an incredible $34.2 billion in 2013. But what's more incredible is that this performance was only a little more than half as good as the S&P 500. It is clear that Berkshire is firing on all cylinders, yet still struggling to keep up.
Value Creation vs. Value Destruction
Early in Buffett's career, when he acquired a company it served as fuel to further propel the company. Berkshire's history before Buffett was as a struggling textile manufacturer which surely didn't have much of a future. Buffett brilliantly diversified the company first into insurance and then into other high-quality operating companies which were rich in cash and cash flows. This started a virtuous cycle of new sources of cash delivering additional capital that funded even more investments. This created an enormous snowball of capital that grew and grew and the "value creation" was clear.
However as Berkshire grew in size, this activity morphed more into that of feeding a monster. In order to keep generating outsized returns, Berkshire had to keep acquiring larger and larger companies. Those companies were almost without exception fantastic businesses and would have provided long-term successful investments for their shareholders with or without Berkshire. However, once they were acquired by Berkshire, shareholders of those companies were often left with either cash or shares of Berkshire which may not have performed as well as the investment they were holding before the Berkshire acquisition.
How would GEICO have performed in the public markets between 1995 and now? Probably very well, and perhaps even better than Berkshire did during the same period, but we'll never know because once Berkshire snapped it up we lost the ability to invest in that company. How about Iscar, FlightSafety, MacLane, Lubrizol or Burlington Northern? Would those shareholders have been better off being able to hold investments in those companies rather than be forced to cash out or invest in Berkshire just as its performance began to lag the S&P 500? Is Berkshire's acquisition activity still value creation, or is it value destruction?
Internally, Berkshire's businesses and managers continue to shoot the lights out. Ajit Jain created an insurance business from a standing start that now has $37 billion in float and delivers enormous profits. Profits at Berkshire's Mid-American subsidiary are more than 14 times higher than they were in 2012, and they were pretty good then. The equity portfolio has grown from $49 billion to $117 billion in 5 years. Yet, for the past 5 years Berkshire has failed to meet its benchmark. All of this business brilliance is simply lost like gold needles in a stack of hay.
There is a lot of talk about who will succeed Buffett, and they will certainly have large shoes to fill. Berkshire will in many ways be an easy company to run, since it has been so well constructed and is rich with high-quality businesses and managers and an excellent culture. However the key question for shareholders is, how can its new manager(s) hope to perform reasonably vs. the market if Buffett himself can't do it?
The only answer to this question is that Berkshire must somehow substantially decrease its capital base, through dividends, buybacks, or spin-offs. Buffett has historically been staunchly opposed to all of these, and only recently has begrudgingly begun to buy back stock, but only in modest amounts. Berkshire continues to obsessively retain all of its capital and consume more wonderful businesses, even while it underperforms, and while investments that would be home runs in either the public markets or in smaller companies are completely invisible to shareholders because they do not move the needle. Berkshire shareholders have every right to ask pointed questions of Buffett and to realistically reassess their investment in Berkshire to determine if it will really perform adequately. It is no longer a question of whether or not Berkshire can match its past performance, which is an absolute impossibility. Now it is a question of whether or not Berkshire can even deliver adequate returns going forward.